Question

How does a black market are often created by price controls with the concept of deadweight loss?

Answer 1

Black market is the proceeds of an illegal transaction, on which income and other taxes have not been paid, and which can only be legitimised by some form of money laundering. Because of the clandestine nature of the black economy it is not possible to determine its size and scope.

When the government sets a price ceiling for a competitive market there are several inevitable immediate consequences. Since the price ceiling is below the equilibrium price , the quantity demanded is greater than the quantity supplied. This means there is a shortage. Buyers cannot buy as much as they would like to at the controlled price. This leads to other consequences such as  a black market may develop for those who do not get the product at the controlled price.

Deadweight loss can be stated as the loss of total welfare or the social surplus due to reasons like taxes or subsidies, price ceilings or floors, externalities and monopoly pricing. It is the excess burden created due to loss of benefit to the participants in trade which are individuals as consumers, producers or the government. It is the loss of economic efficiency in terms of utility for consumers/producers such that the optimal or allocative efficiency is not achieved.

Example: if a certain tax is imposed on the producer for each unit of the good he sells, it is likely that the new equilibrium price that is settled for the transaction will be higher and therefore some burden of this will be passed on to the consumer.

This will lead to reduced trade from both sides. The loss of welfare attributed to the shift from earlier to this less efficient market mechanism is called the deadweight loss of taxation. This leads to wastage or underutilization of resources due to inefficient market outcome.

black market are often created by price controls

Price controls are government-mandated legal minimum or maximum prices set for specified goods. They are usually implemented as a means of direct economic intervention to manage the affordability of certain goods.

Over the long term, price controls inevitably lead to problems such as shortages, rationing, deterioration of product quality, and black markets that arise to supply the price-controlled goods through unofficial channels.

• At best, price controls are only effective on an extremely short-term basis.

Black market transactions usually occur “under the table” to let participants avoid government price controls or taxes.

Example of Deadweight Loss

Imagine that you want to go on a trip to Vancouver. A bus ticket to Vancouver costs $20, and you value the trip at $35. In this situation, the value of the trip ($35) exceeds the cost ($20) and you would, therefore, take this trip. The net value that you get from this trip is $35 – $20 (benefit – cost) = $15.

Prior to buying a bus ticket to Vancouver, the government suddenly decides to impose a 100% tax on bus tickets. Therefore, this would drive the price of bus tickets from $20 to $40. Now, the cost exceeds the benefit; you are paying $40 for a bus ticket from which you only derive $35 of value. In this scenario, the trip would not happen and the government would not receive any tax revenue from you. The deadweight loss is the value of the trips to Vancouver that do not happen because of the tax imposed by the government.

Graphically Representing Deadweight Loss

At equilibrium, the price would be $5 with a quantity demand of 500.

• Equilibrium price = $5
• Equilibrium demand = 500

In addition, regarding consumer and producer surplus:

• Consumer surplus is the consumer’s gain from an exchange. The consumer surplus is the area below the demand curve but above the equilibrium price and up to the quantity demand.
• Producer surplus is the producer’s gain from exchange. The producer surplus is the area above the supply curve but below the equilibrium price and up to the quantity demand.

Let us consider the effect of a new after-tax selling price of $7.50:

The price would be $7.50 with a quantity demand of 450. Taxes reduce both consumer and producer surplus. However, taxes create a new section called “tax revenue.” This is the revenue collected by governments at the new tax price.

With this new tax price, there would be a deadweight loss:

As illustrated in the graph, deadweight loss is the value of the trades that are not made due to the tax. The blue area does not occur because of the new tax price. Therefore, no exchanges take place in that region, and deadweight loss is created.

Calculating Deadweight Loss

To figure out how to calculate deadweight loss from taxation, refer to the graph shown below

Hence black market may be cheaper than legal market prices. The supplier does not have to pay for production costs and or taxes. This is usually the case in the underground economy.  If exchange of goods are made illegal by some sort of state sanction, such as is often seen with certain pharmaceutical drugs, their prices will tend to rise as a result of that sanction.